[phaster]

Been kinda looking at collateralized debt obligations (CDOs) with some interest when I started noticing them mentioned in the financial times about the middle of last year...

just noticed the term started popping up in main sstream american media magazines....

The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges.

http://www.time.com/time/business/artic ... 52,00.html

so since I don't have a back ground economics or finance, thought I'd ask what other people who might have a formal education in economics or finance think is "CDO" going to be in the public lexicon soon?

[MrBill]

CDOs are not the problem. Leverage is. Spreading risk is healthy and makes the financial system more robust. However, increasing leverage increases risk at the same time. At the moment we are seeing a shadow banking system that is larger than the formal banking sector, and although not the same it does put claims on the banking system for liquidity. Even if all CDOs and other derivatives netted out to zero there would still be the risk of contagion via counterpart and settlement risk. The risks are asymmetrical. The gains are concentrated. And not everyone that takes losses can afford them. Those are solvency issues.

[phaster]

subprime loans were bundled together and small parts of the bundle were sold off as investments, so as long long as the economy is good and people are able to service the debt, that is suppose to lower the risk (that part I understand).

By "leverage" do you mean when the economy turns bad and more people can no longer service the debt "solvency issues," so that magnifies the problem? and ya have another way to give me an idea what " counterpart and settlement risk" is?
$this->bbcode_second_pass_quote('MrBill', 'C')DOs are not the problem. Leverage is. Spreading risk is healthy and makes the financial system more robust. However, increasing leverage increases risk at the same time. ... The gains are concentrated. And not everyone that takes losses can afford them. Those are solvency issues.

[MrBill]

Sorry, leverage is simply taking on debt to fund a new investment. If one takes on debt to leverage a CDO or any other derivative it is like buying on margin. It amplifies the risk and the reward. For example, a derivative can be one to one or it can be one to one hundred. If it is one to one hundred leveraged then a one percent move in either direction either doubles one's capital or wipes it out.

The fat tails that everyone keeps talking about is when previously uncorrelated assets all of a sudden start moving in tandem. So if you have bought one asset and hedged it by selling another you get into trouble when they both start to move in the same direction at the same time. This occured because volatility was at historically low levels at the same time as spreads were at historical lows as well. Now volatility is higher a the same time as spreads - or the cost of capital - are also rising. This means selling assets to remain solvent. But if everyone is selling assets at the same time then the prices for those underlying assets fall as well. And if the underlying falls in price then the derivative - in this case the CDO - also falls in price. A vicious downward spiral that is actually simply the mirror image of a virtuous circle, but gone into reverse. We call it a self-reinforcing capital structure. When it is sunny, and there is not a cloud in sight, it is hard to imagine the next storm based on the evidence of a nice summer day. One reason why value at risk (VAR) models often under-estimate those fat tails.

Counterpart risk is simply the person you have contracted with cannot make good on their obligations either because they are not solvent or they lack liquidity or both. If you are part of a chain then when your counterpart fails to deliver cash or securities then likewise you are not able to deliver cash or securities on the other side either. Assuming you have both bought and sold that is. The risk was not that Bear Stearns went bankrupt. The risk was that that Bear Stearns went bankrupt as counterpart to many other trades that would have then subsequently failed as cash or securities could no longer be delivered against contracted obligations. This is the mechanism by which the shadow banking system makes 'a call' on the formal banking system.

Settlement risk is that you deliver the securities, but your counterpart fails to deliver you the cash on a delivery versus payment (DVP) basis. Or vice versa you can pay cash, but your counterpart does not have the securities. This quite often happens when players short the market by selling securities that they do not yet own. If they have trouble buying them in the market then they may default - or delay - delivery on the settlement day. Again this may because of insolvency or lack of liquidity. Again the system wide implications are when one is part of a daisy chain, and due to non-performance it breaks the pass through of risk leaving it concentrated where it is not wanted.

Settlement and counterpart risk is kind of like your house burning down, and finding out your insurance company spent your premium and is now broke. On paper you have insurance, but there is still the risk of being paid out if and when that obligation comes due.

[phaster]

Back about 10 years or so, "long term capital management" was in the news and recall something to the effect that it was a two billion fund that had to be saved because it threated to start a chain reaction in the financial markets because it was leveraged.

Since ya mentioned daisy chain, in your opinion was the magnitude of the leverage of "long term capital management" about the: same, higher or lower "risk" as what would have happend if bear stears were allowed to go belly up as a counterpart to many other trades that would have then subsequently failed as cash or securities could no longer be delivered against contracted obligations.

I've also been watching with interest the proposals, of bernanke and paulson to propose some regulations, do you think that stuff is kinda like closing the barn door after the the mess has occured? In other words I find it interesting that financial types have dreamed up complex investments CDO's, and the trend that you describe " fat tails" of previously uncorrelated assets all of a sudden start moving in tandem seem to be adding lots of complexity and therefore lots of risk. So do you think this little subprime mess is going to get financal markets to get back to simple basic investing ideas (like doing basic analysis of a business or stock investment), as opposed to the complex invests like CDO's that need (VAR) models which sound like they could incorporate some pretty complex math that make some pretty big assumptions about market conditions and can never be 100% sure, cause the markets are ever changing....
$this->bbcode_second_pass_quote('MrBill', 'S')orry, leverage is simply taking on debt to fund a new investment. If one takes on debt to leverage a CDO or any other derivative it is like buying on margin. It amplifies the risk and the reward. For example, a derivative can be one to one or it can be one to one hundred. If it is one to one hundred leveraged then a one percent move in either direction either doubles one's capital or wipes it out. ...

Settlement and counterpart risk is kind of like your house burning down, and finding out your insurance company spent your premium and is now broke. On paper you have insurance, but there is still the risk of being paid out if and when that obligation comes due.

[MrBill]

1. financial markets are very good at not making the same mistake twice in a row, but that does not make them immune from making new mistakes or forgeting about previous mistakes later on.

2. financial regulators as you point out are very good at closing the barndoor after the horses have bolted, but this does not perpare them for the next crisis over the horizon either.

3. we are in a very serious period of deleveraging. That is an ongoing process and will have profound implications on asset prices over years. It may be complicated or exacerbated by post peak oil resource depletion.

4. there is currently a shift from financial assets into physical assets that are perceived by the market as being better stores of value, and a flight to simplicity away from hard to understand and even more difficult to price structured products. The pendulum swings.

5. however, physical assets will become too expensive as too many investors crowd into this sphere. This just sets up the next price bubble and subsequent collapse. Nothing new there.

If I may just use the example of the rice market it is one part scarcity driven; one part speculation driven; one part hoarding driven; and not least of all export restrictions are having the perverse effect of 'balkanizing' the international rice market, so that importing nations are no longer assured of steady supply.

Anecdotal evidence is that less wheat may be planted in some countries this year because export restrictions are holding down domestic prices, while the costs of fertilizer and other inputs like energy are still rising. That is a public policy failure and not a market failure, but guess who will get blamed?

6. and some of those structured products were actually very useful at lowering the cost of capital and spreading risk. I am already working on a large exchangable bond issue and the investor demand is strong. That is to reduce my concentration risk to one market, while giving investors something they cannot get elsewhere. A willing buyer and a willing seller.

7. so the lesson is not this or that asset is good or bad, but their price relative to one another. A house that is both a physical asset and a place to live should be an excellent long-term investment and a store of wealth. But the price of a house should not be totally divorced from local wages and inflation adjusted incomes or rents for that matter. Nor should lenders advance 110% of the purchase price.

We should not confuse poor lending and borrowing decisions with prudent financial intermediation between savers and investors.

8. Long Term Capital was not just a domestic US issue, but took place against the backdrop of the Russian default that in turn took place on the heels of the Tequila and then Asian financial crises. There was a systemic risk of further contagion. The correct policy response was to add liquidity until the market could correctly price and digest the securities at risk from default. And it worked.

9. whereas Bear Stearns is both a liquidity and a solvency issue. It required a different solution. I am sure that JP Morgan was quite happy to be able to offset 'some' of their derivative positions against 'some' of BS' positions thereby reducing their overall exposure (long - short = zero) without seeing those positions dumped on the open market into a dearth of investor interest. Securities that had value would have been priced at less than distressed debt levels (essentially worthless) simply due to an over-supply and an unwillingness (or ability) of investors (banks and hedge funds) to digest that new supply at higher risk premia amid tigher credit conditions.

10. there is no point moralizing about it. There was a significant risk of systemic contagion that could have lead to financial collapse. It was dealt with.

11. however, in its wake regulators, law makers and central banks will demand and get tighter control over non-bank financial institutions (or the so-called shadow banking system). That in turn is driving some of the deleveraging that is undermining support for many asset prices. It is bitter medicine for everyone.

12. I was in London this week and many traders felt like they dodged a bullet. The risk managers and credit officers are calling the shots again. There will still be lots of job losses. But the areas most effected were those esoteric derivative products. Quite rightly so.

So one does get the impression that the wider financial system is safer now than a year ago even though it may not feel like it at the moment. That does not mean that housing or equity prices are all of a sudden going back up. It means a lot of risk has been identified and reduced, while banks and regulators have provisioned for larger losses going forward.

Banking is going to be a lot less profitable in the next ten years than it has been for the past five. The finance industry in general needs to get back to servicing the real economy instead of trading with itself to generate profits.

Using the pendulum analogy this is the counter-reaction to the the Big Bang of financial deregulation that took place in the 90s. Back to basics, but not the end of financial innovation by any stretch of the imagination.

Is that good? I do not know, but I know that regulators, law makers and central banks have created as many problems as they set-out to solve, so that process is ongoing and likely inevitable.

Despite the outcry about 'bailing-out bankers' there is very little public appetite to truly let financial markets free to regulate themselves through greed and fear alone. And once they start to regulate the market they have to make sure their policies and rules are consistant as well as have the resources and the expertise to effectively supervise those markets and financial players.